Looking for relative value in a Basel II world

Highly rated ABS will be among the big winners under Basel II, Morgan Stanley researchers said in a report last week.

The report offered a detailed analysis of how Basel II would impact spreads in the fixed-income market. "What we're interested in here is banks' buy-and-hold investments in a wide variety of fixed income products, and how these investments are likely to change under Basel II," the researchers wrote.

By their analysis, ABS bonds rated triple-B and higher are outright gainers under Basel II, along with CDOs. For an A-rated CMBS tranche, they calculated that a bank's RoE would jump from 7.48% under Basel I to 36.9% under the foundation IRB (FIRB) approach of Basel II.

Triple-B corporate bonds also showed a steep increase, with the absolute RoE more than doubling to10%.

Low-rated ABS and weaker corporates suffered, the researchers found. In line with Basel II's aim to bring regulatory capital more into line with economic capital, the analysis showed that RoEs for C-rated corporates fell from 40% to 15% and for double-B RMBS from 17% to a negative return, the report said.

"Considering the tight spread environment we're in, and the fact that banks are unlikely to start shifting assets until the end of next year, we'd expect a more normalized spread environment to amplify the asset reallocation process of banks," the researchers added.

Shifting a single-A CMBS spread from the current 70 basis points to a new starting point of 84 basis points gives a Basel I RoE of 9.5% against a FIRB RoE of 47.2%, according to the report.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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